The Foundations of Corporate Social Responsibility

[Pages:59]The Foundations of Corporate Social Responsibility

Hao Liang1

CentER for Economic Research, Tilburg University and John M .Olin Center, Harvard University

Luc Renneboog

CentER for Economic Research, Tilburg University and Fellow of European Corporate Governance Institute

PRELIMINARY AND INCOMPLETE: DO NOT DISTRIBUTE NOR CITE

ABSTRACT

We investigate the roles of legal origins and political institutions ? believed to be the fundamental determinants of economic outcomes ? in corporate social responsibility (CSR). We argue that CSR is a crucial path to economic sustainability, and document significantly high correlations between country-level sustainability ratings and various extensive firm-level CSR ratings with global coverage. We contrast different views on how legal origins and political institutions can function on corporations' tradeoff between shareholder rights and stakeholder rights, which is arguably the main underlying mechanism for them to influence CSR. Our empirical evidence suggest that: (a) Legal origins are more fundamental sources of CSR adoption than firms' financial and operational performance; (b) Among different legal origins, the English common law ? widely believed to be mostly shareholder-oriented ? fosters CSR the least, while companies under the Scandinavian legal origin assume most social responsibilities; (c) Political institutions ? democratic rules and constraints to political executives ? are not preconditions for CSR and sustainability, and sometimes even hinder CSR implementation. Our results are robust after controlling for corporate governance, culture, firm-level financial performance and constraints, and different indices of political institutions.

Keywords: Corporate social responsibility, sustainability, legal origins, political institutions, shareholder orientation, stakeholder orientation.

JEL Code: G30, K22 , M14, O10, O57

Acknowledgements

We are grateful to Lucian Bebchuk, Archie Carroll, Martijn Cremers, Hans Degryse, Allen Ferrell, Jesse Fried, Nancy Huyghebaert, Thomas Lambert, Chris Marquis, Pedro Matos, Aldo Mussachio, Dwight Perkins, Mark Roe, Roy Shapira, Andrei Shleifer, Holger Spamann, Sunny Li Sun, Nan Zhou, and the conference and seminar participants at Harvard Law School, Harvard Business School, Tilburg University, University of Cambridge (Judge), Stockholm School of Economics, 10th and 11th Corporate Finance Day (Ghent and Li?ge), 2013 China International Conference in Finance, 2013 Asian Finance Association Conference, Humboldt-Berlin University, and University of Notre Dame (Mendoza) for helpful comments and suggestions. All errors are our own.

1 Corresponding address: 5000 LE Tilburg, the Netherlands. Email: H.Liang@uvt.nl; Luc.Renneboog@uvt.nl

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The Foundations of Corporate Social Responsibility

"Business cannot succeed in a society that fails. Likewise, where and when business is stifled, societies fail to thrive"

-- Bj?rn Stigson, President, World Business Council for Sustainable Development

"Driving shareholder wealth at the expense of everything else will not create a company that's built to last." -- Paul Polman, CEO of Unilever, Harvard Business Review (May 2012)

I. Introduction

A fundamental issue in business and economics is the sustainability ? not merely the growth ? of economic development, which crucially hinges on the socially responsible operational and investment behavior of modern corporations (Porter, 1991). There is now widespread recognition, as well as growing empirical evidence that corporate social responsibility (CSR) can substantially contribute to social progress and stakeholder wealth, including the wealth of shareholders (e.g., Dimson, Karakas, and Li, 2012; Deng, Kang, and Low, 2013). But what forces, among the many documented factors, that fundamentally drive companies to behave as good citizens in the society is still under fierce debate. This is the key question we investigate in this article.

Some Conceptual Issues

Our goal is to discover the foundations of CSR and how such foundations translate into the sustainability of our society. This ambitious research inquiry immediately poses some conceptual issues. To begin, one key issue is what we are actually measuring. Various studies have attempted to model and measure CSR but usually from only one perspective, such as employee satisfaction (Edmans, 2011, 2012), environmental protection (e.g., Dowell, Hart, & Yeung, 2000; Konar & Cohen, 2001), corporate philanthropy (e.g., Seifert, Morris, & Bartkus, 2004), and consumer satisfaction (e.g., Luo & Bhattacharya, 2006; Servaes & Tamayo, 2013; Larkin, 2013). However, CSR is by nature a multidimensional concept, as it captures various stakeholders' interests. In this sense, the most comprehensive concept of CSR is defined

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as and measured by a firm's engagement and compliance in environmental, social, and governance (ESG) issues. It addresses concerns for the environment (such as climate change, hazardous waste, nuclear energy, ecological balance, etc.), society (social diversity, human rights, consumer protection, consumer consciousness, etc.), and corporate governance (including management/board structures and representation, employee relations, executive compensation, anti-corruption measures, etc).2,3

A closely related issue concerns the nature of CSR. As indicated by its very name, CSR is not mainly about regulations and policies, but more about the corporations' tradeoff between shareholders' rights and stakeholders' rights. The concept of stakeholders includes shareholders, but also involves other stakeholders who do not necessarily have the same interests and claims from the firm as shareholders do. Therefore, our theoretical base is how the underlying "foundations" function through such shareholder-stakeholder tradeoff.

Some scholars, such as Friedman (1970), Jensen (2001, 2002), and most recently Chen, Hong and Shue (2012), are skeptical that CSR is a value diversion activity that does not contribute to aggregate social welfare and sustainability. In this paper, we quantify this CSR-sustainability relationship by showing that comprehensive firm-level CSR scores are significantly correlated with country-level sustainability ratings in many dimensions.4 Some correlations are almost 30% which is substantial given that the CSR scores and country sustainability ratings are from very different data sources and use different rating metrics. These significant correlations imply that CSR is closely linked to economic sustainability, which represents the preservation of resources, order, and wealth. We argue that CSR is a crucial path to economic sustainability and they have similar macro foundations. Therefore, although our focus in this paper is on the firm-level CSR adoption, in most cases we also refer to the country-level sustainability interchangeably throughout the rest of the paper.

The Literature

Most of the extant literature relates CSR to the firm's financial and operational performance (`doing well by doing good'), or studies the inverse, whether it is only well-performing firms that can afford to adhere to

2 Similarly, The European Federation of Financial Analysts Societies (EFFAS) interprets ESG as the need to focus on: (1) energy efficiency, (2) greenhouse gas emissions, (3) staff turnover, (4) training and qualification, (5) maturity of workforce, (6) absenteeism rate, (7) litigation risks, (8) corruption, and (9) revenues from new products. 3 In some definitions and measurement of CSR, the "G" component is often taken out as it coincides with the traditional corporate governance concerns. In such case, the main focus of CSR is on the external non-shareholder issues. 4 The firm-level scores are from thes CSR databases (some are proprietary): the MSCI corporate ESG ratings, MSCI Impact Monitors, Vigeo corporate ESG ratings, and Asset4 corporate ESG ratings, all with global coverage. The country-level sustainability ratings are from the Vigeo Sustainability Country Rating.

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ESG criteria (`doing good by doing well'). Both the theoretical models and empirical evidence are rather ambiguous on the causality in this relationship. The theoretical debate on doing well by doing good started with the Porter hypothesis (Porter, 1991; Porter and van der Linde, 1995): the financial benefits from innovation induced by CSR more than offset the engagement and compliance costs. Furthermore, a good ESG rating also enhances a firm's reputation as a decent company (manager) which (who) respects its employees, communities, and the environment, and thus increases the financial returns for investors (Guenster, Bauer, Derwall & Koedijk, 2011). Whereas some recent papers have studied the profit motives for CSR (Hong, Kubik and Scheinkman, 2011, Chen, Hong and Shue, 2012), others concentrate on the question as to how delegated philanthropy and the stakeholder theory (Tirole, 2001; Benabou and Tirole, 2010) can explain why firms are doing good by doing well. Stakeholders require that corporations engage in socially responsible behavior and thereby be willing to sacrifice profit for a good cause. The most profitable firms (or least financially constrained firms) are most able to afford the expenses of adopting a CSR policy. While some evidence is found for both the theoretical arguments underlying doing good by doing well (e.g., Hong et al., 2012) and doing well by doing good (e.g., Orlitzky et al., 2003; Dowell et al., 2000; Bauer et al., 2011), a causal relationship cannot be identified or is statistically insignificant (Margolis, Elfenbein and Walsh, 2007). Besides the ambiguous theoretical predictions and empirical evidence, some unexplored exogenous and latent factors may influence both doing good (representing the stakeholders' interests) and doing well (representing mainly the shareholders' interests) simultaneously. Apparently in response to this concern, some more recent studies go one step further to investigate the governance determinants of CSR (such as Johnson and Greening (1999), Barnea and Rubin (2010), Li and Zhang (2010), and Lopez-Ithurriage & Lopez de Foronda (2009)). However, these are mostly single-country analyses and not really analyze the latent factors but rather another set of endogenous firm-level variables. Ioannou & Serafeim (2012) investigate the association between "national institutions" and the score on the CSR index. However, most of their measurements on "institutions"5 are not truly institutions with persistent and durable features (as defined in North, 1980), but rather the economic consequences of institutions (Glaeser, La Porta, Lopez-de-Silanes, Shleifer, 2004), which implies that those proxies for institutions may still be endogenously determined. This motivates us to think deeper about the potential fundamental and latent (and thus other than financial and operational) determinants of CSR, as well as their different effects on

5 These variables include the measurement of regulations promoting competition, the level of corruption, leftist political ideologies, the power of labor unions, the availability of human capital, the presence of market-based financial systems, the existence of CSR stock market index, etc.

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shareholders and stakeholders.

Currently, the consensus in finance and economics on the fundamental factors of economic outcomes are the institutional arrangements that define rules and rights, such as legal origins (e.g., La Porta, Lopez-de-Silanes, Shleifer, and Vishny [hereafter LLSV] 1997, 1998; La Porta et al., 2008) and the political institutions (e.g., Rajan and Zingales, 2003; Pagano and Volpin, 2005; Perotti and von Thadden, 2006; Roe, 2003, 2006). The institutional framework of a country determines key structural features of the firm (Matten & Moon, 2008), "including the degree to which private hierarchies control economic processes, the degree of discretion owners allow managers in running the company, and organizational capabilities to respond to changing and differentiated demands (2008: 408)." Meanwhile, according to the theory of the firm (Williamson, 1981), the firm is to be seen as a nexus of contracts between interested parties ? in addition to shareholders, these are customers, suppliers, owners, managers, employees and communities ("stakeholders")6 ? who realize economic gains through their participation in these contractual relationships. Therefore, we expect that these historically established laws and institutions which define rules and rights for stakeholders, rather than financial performance and constraints, are the more basic source of CSR. In this paper, we contrast two competing views ? the principal-agent view versus the stakeholder perspective ? on legal origins, as well as two competing views ? the institutional view versus the development view ? on political institutions to address their fundamental impact on CSR and sustainability.

Our paper contributes in the following ways. First, while the majority of cross-country studies on the role of fundamental institutions focus on country-level differences and use macro-level data (e.g., Acemoglu et al., 2001; Acemoglu & Johnson, 2002, 2005), which usually suffer from small sample inference and sensitivity to outliers, our unit of analysis is the firm for which we have extensive proprietary data on their performance on ESG issues. The fact that we combine a macro- and micro-level analysis enables us to better understand the mechanisms of how fundamental institutions determine corporate behavior. Second, our data enable us to differentiate between CSR engagement and compliance, which has not yet been explored to date. However, as we show later, the impact of laws and institutions does not distinguish between these two aspects of CSR. Third, our study has policy and welfare implications: if institutional

6 The stakeholder perspective dates back to Edward Freeman's (1984) influential book Strategic Management: A Stakeholder Approach. The book describes and recommends the methods by which management can give due regard to the interests of the stakeholder groups. Similar definitions and arguments can be found in Donaldson and Preston (1995), Mitchell, Agle, and Wood (1997), Tirole (2001), Friedman and Miles (2002) and Phillips (2003).

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origins are found to be of first-order importance, then policymakers could imitate the tools associated with the winning origin and shun those associated with the loser (Roe and Siegel, 2009). Hence, our empirical findings can offer a guide for institutional reform aiming at stimulating economic and societal sustainability. Many large corporations and countries worldwide today find it hard to achieve good citizenship and sustainable development, in part because of their institutional heritage.

The rest of the paper is organized as follows. Section II revisits the roles of legal origins and political institutions that have been documented in the literature as fundamental determinants of corporate behavior and economic outcomes, and discusses their theoretical relevance to CSR and sustainability. Section III describes our data and empirical strategies. Section IV exhibits the empirical results while Section V discusses the validity of alternative explanations on our results. Section VI concludes with theoretical and policy implications.

II. Institutional Origins, Finance, and Corporate Social Responsibility

A considerable body of economic research has suggested that the historical origins of a country's laws and political institutions are highly correlated with a broad range of its legal rules, regulations, and modern political systems, as well as with economic outcomes (La Porta et al., 2008; Acemoglu and Johnson, 2005). Therefore, our baseline hypothesis is that CSR and sustainability ? both as crucial economic outcomes ? are also fundamentally governed by these origins. What similar or different effects the institutional origins have on CSR and sustainability are central to our inquiry. In this section, we revisit the theoretical framework of legal origins and political institutions, and try to identify how they matter for CSR.

II.1. Revisiting the Roles of Legal Origins

The fundamental roles of legal origins on economic outcomes are advocated by La Porta et al. (1997, 1998) and have been adopted by much of the law and finance literature. The legal origin theory argues that the largely exogenous legal origins ? common versus civil law, and the legal subfamilies within the civil law tradition such as German, French, and Scandinavian legal systems ? set legal rules and their enforcement, which differ in terms of the priority to protect the rights of private investors vis-a-vis the state (Beck, Demirg??-Kunt & Levine, 2003) and the mutual rights of different types of investors (shareholders versus creditor; majority versus minority shareholders). These differences form the basis of contracting and capital market development that is believed to be the foundations of financial and economic prosperity.

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Since the seminal work by LLSV (1998), it has almost become a convention that the English common law system is globally superior to other civil law systems in protecting investor rights and facilitating desirable economic outcomes.7 Various studies argue that the standards of the common law system are those to which corporate governance practices worldwide are converging (e.g., Hansmann and Kraakman, 2001; Goergen and Renneboog, 2008; Aggarwal, Erel, Stulz & Williamson, 2009).

There are two distinct views on the roles and effects of legal origins. The predominant view of legal origins ? the "law and finance" view ? rests on the principal-agent paradigm. Under this paradigm, corporate law aims to address the agency conflicts between managers and shareholders (under a dispersed ownership structure) and between controlling and minority shareholders (under concentrated ownership). The common law origin is inherently linked to better protection of shareholders against the corporate management. However, stakeholder rights are vaguely defined under the principal-agent paradigm. Sacrificing profits to social interests can violate the shareholder primacy principle and fiduciary duty embedded in company law, especially in common law countries. Protecting the interests of other constituencies is thought to be counterproductive and economically inefficient, as long as it cannot be explained by "enlightened shareholder value" (Gelter, 2009). Therefore, maximizing shareholder value is also maximizing social value, which is central to the principle of capitalism (Williamson, 1985).

The alternative view ? the stakeholder capitalism perspective ? answers why companies exist and take the demands of other stakeholders on the firm's resources into account. In this view, the company should be managed for the benefits and needs of all stakeholders, not merely its shareholders, in order to gain legitimacy in society (Freeman, 1984). Purely focusing on the maximization of shareholder value does not necessarily lead to the maximization of social wealth in the long run, and could create large externalities. In the comparative corporate governance literature, the civil law traditions are more characterized by such stakeholder orientation than the common law one (Matten & Moon, 2008). For example, in Germany, firms are legally required to pursue the interests of parties beyond just shareholders through the system of co-determination in which employees and shareholders in large corporations have an equal number of seats on the supervisory board of the company (Allen, Carletti, and Marquez, 2009). The "harmonization" laws of the European Community include provisions permitting corporations to take into account the interests

7 However, the superiority of the common law has been questioned in some other studies. For example, Roe (2006) argues that the outperformance of common law countries in financial development is not due to legal origin, but due to the postwar legislatures and political ideologies. Spamann (2010) reconstructed the LLSV's legal data, and concludes that the superiority of the common law is not valid.

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of creditors, customers, potential investors, and employees (Orts, 1992). The corporate governance model in Japan ? through both law and custom ? presumes that Japanese corporations exist within a tightly connected and interrelated set of stakeholders, including suppliers, customers, lending institutions, and friendly corporations (Donaldson & Preston, 1995).

Both views on legal origins are rooted in the shareholder-stakeholder tradeoff and have strong implications on CSR and sustainability. The law and finance view favors the common law tradition, while the stakeholder view favors civil law system to maximize social wealth over the long run. In addition to these debates on the fundamental roles of legal origins, many have argued that legal origin cannot fully explain the cross-country variation in economic outcomes, and ought to be complemented by an institutional view (e.g., Rajan & Zingales, 2003; Pagano & Volpin, 2005; Roe & Siegel, 2009; etc) Therefore in the next section, we review the political institutions as alternative origins of CSR.

II.2. Revisiting the Roles of Political Institutions

The determinant roles of political institutions on economic outcomes ? in particular economic growth and financial development ?have been advocated in recent years by Acemoglu et al. (2001, 2002, 2005), Easterly & Levine (2003), Rodrik, Subramanian, & Trebbi (2004), and Roe (2006). The political institutions refer to the set of rules such as democracy, the electoral rules, the legislative procedures, the constraints to the political executives, etc (North, 1981; LLSV, 1999; Shleifer & Vishny, 1993; 1994; Glaeser, La Porta, Lopez-de-Silanes, & Shleifer, 2004; Roe, 2006; Matten & Moon, 2008). The conventional wisdom is that good institutions lead to good economic outcomes. Well-established institutions such as democracy and constraints on government protect investors and facilitate business transactions, thus are the preconditions of financial development and economic growth.

We also contrast two different views on political institutions: (1) the institutional view which regards political institutions, democracy in particular, as a pre-condition of economic outcomes, and (2) the development view which considers democratic participation as a consequence of economic development. The institutional view, often seen as `conventional wisdom', considers good institutions as the fundamental determinants of good economic outcomes (Acemoglu & Johnson, 2005). Here, the degree of democratic participation determines to what extent other stakeholders (including shareholders and creditors) can have in terms of active political participation and vote to influence decisions. The prevalence of democratic suffrage institutions facilitates broader access to finance (Barth, Caprio, and Levine, 2006) and helps

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